Netflix and the Economics of Bundling

Executive Summary

How does Netflix get away with releasing its movies in theaters on the same day it makes them available for “free” on its streaming platform? The answer is that Netflix is pursuing a fundamentally different business model from everyone else in the industry. Netflix is not in the business of selling individual movies to many different customers. Instead, it’s in the business of selling many different movies to individual customers—in bundles. Bundled subscriptions allow Netflix to practice a different kind of price discrimination from the movie studios. The company doesn’t have to figure out how much a consumer values any individual movie on the service. The bundle does that for them—very profitably.

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This is shaping up to be a breakout year for Netflix. On January 22, the former DVD-rental company became the seventh member of Motion Picture Association of America. That same day, it received 14 Oscar nominations, more than it had received in all its prior years combined. And on Sunday night, it had arguably its biggest night ever, by winning four Oscars — tying it with Disney, Fox, and Universal for the most Oscar wins by a major studio in 2019. In just over a month, Netflix solidified its position as an insider in the theatrical business in every way.

Well, in every way but one: Netflix still doesn’t “release” its movies in theaters.

Sure, occasionally you can see a Netflix film in a limited showing at your local art-house cinema, but even then Netflix breaks with industry norms. Instead of using an exclusive theatrical release, Netflix movies are almost always available to stream the same day they are released in theaters. And on the rare occasions where Netflix movies are shown first in theaters, it’s only a few weeks before Netflix makes them available for streaming online—nowhere near the 90-day exclusive window used by every other major Hollywood studio.

This raises an important question. How can Netflix be so successful while rejecting the most important part of the business: the theatrical release?

To answer that question, it’s important to understand why, for decades, Hollywood studios used an exclusive “windowing” model to release their films. And this starts with an important insight: consumers place radically different values on watching a movie. Some might value it at $15 (“I’ve got to see that new Star Wars movie today!”); others might value it at only $5 (“I wonder what I should rent tonight?”). Studios obviously want to extract as much value as they can from each group without cannibalizing sales to the other.

Studios figured out a long time ago that the most profitable way to accomplish this goal was to strategically vary the timing, quality, and usability of their movies, so that high-value consumers would voluntarily pay a high price for a movie that other consumers will see for less. The theatrical release was the key to making this price-discrimination strategy work. Making a movie available exclusively on “the big screen” allowed studios to segment their (impatient, quality-conscious) high-value customers from the rest of the market. Why else would anyone pay $15 for a theater ticket if they could rent the same movie for $4.99 a few weeks later?

So far, so good. But then why does Netflix release its movies in theaters on the same day it makes them available for “free” on its streaming platform? The answer is that Netflix is pursuing a fundamentally different business model from everyone else in the industry.

Netflix is not in the business of selling individual movies to many different customers. Instead, it’s in the business of selling many different movies to individual customers—in bundles. Bundled subscriptions allow Netflix to practice a different kind of price discrimination from the movie studios. The company doesn’t have to figure out how much a consumer values any individual movie on the service. The bundle does that for them—very profitably.

Bundling works in an interesting way. We’ve written about this at some length in Streaming, Sharing, Stealing, a 2016 book about the changing nature of the entertainment industry. In brief, the more products a seller can offer consumers in a bundle, the better that seller can predict the average value of the bundle across different consumers. Not every consumer assigns the same values to the individual movies in the bundle, but in a large bundle that doesn’t matter: the differences in the individual values average out. If a seller can accurately predict the average value a subscriber is willing to pay for all the movies in the bundle, then it can set a price just slightly below that value and extract the maximum value possible from its audience.

As we note in our book, this is why streaming platforms like Netflix pursue unorthodox strategies for theatrical releases. Compared to the studios, they have very little to lose. In the traditional business model, messing up the theatrical release window puts the entire business at risk. But Netflix sees things differently. If the company can make some money or win some awards by releasing its movies in the theaters, that’s great. But it doesn’t need a successful theatrical release to generate profit from its movies.

The problem is that it’s hard to understand Netflix’s strategy from the perspective of the established business model. In November 2018, John Fithian, President of the National Association of Theaters Owners criticized the streamer, asking, “Wouldn’t Netflix make more money and establish a much deeper cultural conversation by offering a true and robust theatrical run first, and offering exclusive streaming to its subscribers later?”

With all due respect, we believe Mr. Fithian has it backwards. Couldn’t the studios make more money by adopting the model that Netflix is using?

Actually, that’s exactly what they are doing. The horizontal merger of Disney and Fox and the vertical merger of Warner Brothers and AT&T are both designed to exploit Netflix’s bundled strategy of selling movies. As more studios embrace this new business model, we believe they will see how bundling benefits both the bottom line and their audience.

But bundling carries one other important benefit: It allows great artists to tell great stories — stories like Alfonso Cuarón’s Oscar-winning movie Roma. In an interview last month, Cuarón noted that Netflix had allowed him to make a film that would have never been made in a traditional theatrical release. “I made a movie that on paper seems very unlikely and very difficult,” he said. “It’s a drama, it’s not a genre film, it’s black-and-white, it’s in Spanish and Mixtec. When it was presented, the actors were not recognizable. It was like something that could have ended in just one theater in LA, and one theater in New York, and one theater in several cities around the world.”

Netflix should be proud of what it made possible for Cuarón, and it should be proud of the awards it won last night. But what the company should really be proud of, and what has truly made it an insider in the entertainment business, is that it has come up with newly effective and profitable ways of doing what has always defined success in the entertainment industry: Using new technologies to create engaging stories, and using the right business models to bring these stories to the audience.

Michael D. Smith is a professor of information technology and marketing at Carnegie Mellon’s Heinz College and Tepper School of Business.

Rahul Telang is a professor of information systems and management at Heinz College.